Are Hedge Funds and Private Equity Firms Next?

As widely reported, President Obama came out swinging yesterday against large financial institutions. Under the administration’s proposal, commercial banks no longer could invest in or sponsor hedge funds or private equity firms, and the banks would be subject to new leverage caps. This proposal is the most recent step by the administration to try to regulate risk. According to President Obama, “We simply cannot accept a system in which hedge funds or private equity firms inside banks can place huge, risky bets that are subsidized by taxpayers and that could pose a conflict of interest.” (Full text of speech here.)

As you might imagine, the financial sector is highly critical of the proposal (for example, see here) and some commentators are questioning whether it is feasible given the structure of firms like Goldman Sachs (for example, see here) and the global nature of the economy (and mixed reactions from the U.K. and Europe so far, see here and here). You also have to wonder what is next. Given Tuesday’s election results (for a discussion of resulting policy shifts, see here) and the reappearance of Paul Volcker on the scene, those aspects of the Group of 30 report, Financial Regulatory Reform: A New Foundation, previously not pushed by the administration might be back on the table. Indeed, the administration previously downplayed the need to restrict the size or activities of large financial institutions: “We have created them [i.e., large financial institutions], and we’re sort of past that point, and I think that in some sense, the genie’s out of the bottle and what we need to do is to manage them and to oversee them, as opposed to hark back to a time that we’re unlikely to ever come back to or want to come back to.” (Comments of Diana Farrell, Deputy Director of the National Economic Counsel.)

If that is the case, will we see a renewed focus on hedge funds and private equity firms? They were among the initial targets of public anger and Congressional inquiry, but little has been done with The Hedge Fund Transparency Act of 2009 or the more aggressive oversight proposed by the Group of 30 report. And will any of these efforts really mitigate financial risk in the market? Even if you believe that some government intervention is necessary, is the government really equipped to perform a meaningful oversight role?

2 Responses

The word “hedge” has a specific meaning in economics. In that usage, a hedge is a good thing for the person buying it (i.e., limiting unaffordable downside risk) and a good thing for the person selling it (accepting an affordable downside risk in return for an upside opportunity.) The affordability issue is the reason there have long been restrictions on certain types of speculation, limiting them to “sophisticated investors.”

More recently, though, the subversion of the term “hedge” has become total. A “hedge fund” has nothing to do with hedging. It is merely a vehicle by which speculators can do whatever they want without annoying and inconvenient restrictions designed to protect the market.

If we [more accurately] called them “unrestricted speculative enterprises” then perhaps the reaction against regulating them might be different.

Your comment is so timely; I was just reading an article about farmers turning to derivatives to hedge risks posed to their crops by weather, etc. And you are right, in economics, the term “hedge” generally is a positive term that corresponds to value preservation.

With respect to “hedge funds,” my understanding is that the term originated with private funds that hedged market risk with short-selling strategies. Nevertheless, regardless of its origin, you also are right that the term now engenders very negative images. Perhaps a more accurate name would help people understand the distinction between “hedging” and “hedge funds.” I also think our tendency to generalize about terms and investment funds contributes to the problem.